Capital Gains Tax – What’s the problem that it solves?

“We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.”
― Winston S. Churchill

Capital Gains Tax. What’s the problem that it solves?

But first, some facts:

1 – What is ‘Capital Gains Tax’. Simply put, it’s taxing the tree. Currently, in NZ, you pay tax on income derived from physical exertion (labour) ie the fruit, you pay tax on earnings that come from capital (leaves), but you do not normally pay tax on the tree itself (the increase in the value of the capital itself). Under the proposed legislation the gain in the value of your capital whether held in property or shares (in Australasia) would be payable in addition to the income tax you paid in order to acquire that asset (as well as the dividend, interest or rental income also received.)

2 – What’s the likelihood that the proposed CGT will go ahead as proposed?

Well, most would suggest it’s a certainty that it will only proceed after some fine-tuning. Originally it was discussed the changes in tax around capital gains would be tax neutral, having the effect of redistributing wealth from the ‘haves’ to the ‘have-nots’.

This is where politics and the safety net of our democratic system come into play (assuming most Kiwi’s understand the impact of the proposed CGT and express their opinion not just on facebook but at the polls) – ultimately what’s best for NZ is what the majority think it should be…right?

The natural question that follows on from this likelihood piece is this: will a capital gains tax, complete with the myriad of side effects, be an effective solution?

3 – How will the proposed tax changes affect the everyday New Zealander?

This will impact every Kiwi – for richer or for poorer. Hopefully out of this there’s going to be some healthy debate around the following questions:

Will this be perceived to be ‘punishing’ those who take a risk, innovate, build wealth and employ Kiwis? Even if it’s not punitive, will it be perceived like that?

Will the ‘middle’ or those aspiring to build wealth, pay the bulk of the cost for the upper 1% who will likely find ways still to avoid paying this tax?

Will those with wealth move to another country? Well, if they do they could be paying tax on the way out!

Will this remedy in any part, the housing crisis? Some would suggest that the value of lower-priced homes (typically homes that are acquired by property investors) will fall at a greater rate relative to larger owner-occupied style homes (the ‘mansion effect’)

Fair Dividend Rate (FDR) taxation rules applied to overseas shares may be more appealing now in light of a new CGT on the gains on shares held in Australia and NZ. Is this something that the NZX really needs right now and if seeking capital, would a startup or SME be able to resist a growing temptation to move off-shore?

Covering a topic like Capital Gains Tax can be challenging to say the least – inevitably it gets clouded by our own political bias and pre-conceived notions around equality. To ensure a rational debate here we really should be looking primarily at the problem that the CGT attempts to solve, then after that ask this very important question – is this going to be an effective tool in solving that problem?

In my opinion, the problem that CGT attempts to solve has not been defined clearly enough. If a CGT could solve a clearly defined problem then I think, like many, we’d just have to adopt it and move on. I’m not sold on it though as proposed (even some members of the tax working group itself aren’t sold on it).

Let’s not overlook two other (relatively) new tax levers that have recently been pulled:

a – The Bright Line Test (extended from 2 years to 5 years around this time last year) taxes the gains made on residential property (outside of the primary residence) at your marginal tax rate.

b- Ring-fencing of tax losses. This rule change is almost guaranteed to go through with an effective date being 1/4/19. If you make a ‘loss’ on a rental property traditionally you’ve been able to offset that against your personal income tax liability. These losses will soon be ‘contained’ and whilst it may offset future taxable income from property, there may soon be no immediate tax relief that we currently enjoy. In a podcast episode with accountant Karl Moreton, we delve deeper into these two issues separately (check it out)

We haven’t yet seen the full impact on our economy and the overall tax-take from these two changes – anecdotally we’ve observed a clear change in the property market already – possibly due to this and the correlation effect between NZ and Australia. Is now really the best time? Is this really going to be an effective solution? And oh yeah, what’s the problem we’re trying to solve again?